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Did you get burned during the dot com bubble? Did you lose a bunch on online pet food stocks? What about the real estate and credit market implosion? Did you get burned there too? Many people did. Many only had a strategy based on markets going up forever. We all know how that turned out. Does everyone lose at bad times? No. There are winners. They are the trend followers. They are not the mutual fund owners. First piece of education? If you own mutual funds...sell them all tomorrow!
What is trend following? Trend trading is reactive and systematic by nature. It does not forecast or predict markets or price levels. Prediction is impossible! Trend trading demands that you have strong self-discipline to follow precise rules (no guessing or wild emotions). It involves a risk management system that uses current market price, the equity level in your account and current market volatility. Trend traders use an initial risk rule that determines your position size at the time of entry. This means you know exactly how much to buy or sell based on how much money you have. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements may lead to an exit for your entire trade. Historically, A trend trader's average profit per trade is significantly higher than the average loss per trade.
Trendtrading is not a Holy Grail. It is not some passing fad or hyped-up secret black box either. Beyond the mere rules, the human element is core to the strategy. It takes discipline and emotional control to stick with trend trading through the inevitable market ups and downs. Keep in mind though, Trend Followers expect ups and downs. They are planned for in advance. What must all trend followers consider?
Price: One of the first rules of trend following is that price is the main concern. If a market is at 60 and goes to 58, 57, 53 - the market is in a down trend. Despite what every news show might predict, if the trend is down, stay with the trend. A trader need only be concerned with what the market is doing, not what the market might do. The price tells you what the market is doing. Think about Bear Stearns, Lehman Brothers, WaMu, IndyMac, AIG, Fannie Mae, Goldman Sachs - didn't their down trends tell you all you needed to know? Did you fall for the nonsense that they would all bounce back?
Money Management: The most critical factor of trend following is not the timing of the trade or the indicator, but rather the determination of how much to trade over the course of the trend.
Risk Control: Trend following is grounded in a system of risk control and money management. The math is straightforward and easy to learn. During periods of higher market volatility, your trading size is reduced. During losing periods, positions are reduced and trade size is cut back. The main objective is to preserve capital until more favorable price trends reappear. Cutting losses is the way to stay in the game.
Rules Rule: Trend following should be systematic. Price and time are pivotal at all times. Trend Following is not based on an analysis of fundamental supply or demand factors. Trend Following does NOT involve seasonals, point and figure, Market Profile, triangles or day trading.
Trend Following answers these critical questions:
- How and when to enter the market.
- How many contracts or shares to trade at any time.
- How much money to risk on each trade.
- How to exit the trade if it becomes unprofitable.
- How to exit the trade if it becomes profitable.
Video Introduction to Trend Trading
Conclusions
If you want in-and-out day trading, we can't help. Good trend following systems average five or six trades per market per year. Good trend following systems ride big winners and cut short small losses. What do you need to get started?
- An active mind, willingness to learn and passion to win.
- No knowledge of what an Italian bond is worth or what companies comprise the S&P or FTSE index. The key to trend trading is the price on the chart.
- Discipline and common sense to do the right thing per all rules.
- About an hour each day at the end of the day to check trades.
- A PC and telephone line (or internet connection).
Trading is a zero-sum game. For every winner, there is a loser. What's the difference between winners and losers? Smarts and strategy. For every loser in the NASDAQ implosion or the real estate/credit meltdown there was a winner. Does this mean that there are traders with neither strategy nor smarts actively losing, effectively shifting their funds to the winners, armed with strategy and smarts? Yes, absolutely.
